understand your financial statements
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Understanding Financial Statements

Taking time to read your financial statements might not be the most exciting part of running your own business, but they are a key reporting tool that help you understand the state of your business and where it’s going. Your financial statements are also an essential tool to help you make important business and investment decisions, such as cost management, continuing or discontinuing a business operation, mergers and acquisitions, forecasting, and buying or leasing equipment.

There are four main financial statements:

  • Balance Sheet
  • Profit and Loss
  • Retained Earnings/Deficit, and
  • Cash-Flow

To help you grasp a better understanding of these statements, here are the answers to the five most common questions small business owners ask their accountant.

Q. Why Are Some Assets Reported in the Financial Statements at Cost and Some at Fair Market Value?

An assets value depends on your intention for acquiring them, how you want to use them. For example, if you invested in a portfolio with the intention of trading the assets, you would typically measure this at fair value. On the other hand, if you intend to hold the investment until maturity you would measure the assets based on their cost. However, assets such as property, plant and equipment are usually reported on the cost basis, less depreciation.

You may ask, why not use one approach to all these items? Unfortunately, there is no simple answer to this question. The The Accounting Standards Board (AcSB) sets most of these standards, after consulting with various interest groups, such as business owners, investors, creditors, and government authorities. The argument for fair market value is that it makes accounting information more relevant for investors and creditors. However, to appraise property, plant and equipment at fair value can be costly, requiring you to hire a professional appraising company to assess each asset. And even then, the result may be less relevant to investors.

Q. What is the Difference Between Capital Asset and Current Expense?

Any expenditure which has a useful life of more than a year will most likely be capitalized. In other words, you can receive an economic benefit in the future from that asset. Examples include land, building and equipment. These assets are recognized as expenses after they have been used up in the business.

Expenses represent immediate decrease in economic benefits. Generally, current expenses are everyday costs of keeping your business going, such as the rent and utility bills.

Sometimes the distinction between assets and expenses is subtle. For example, in a construction project all building costs, including interest, material and labor will only be capitalized and expensed when you will sell the finished building.

In a few cases, corporations have a choice of whether to categorize certain expenses as assets or as expenses. For example, research and development costs. This assessment involves complex professional judgement procedure based on estimates disclosed in the notes to the statements.

Q. What is the Difference Between the Income Statement and the Statement of Cash Flows?

Your income statement represents your revenue and expenses for a period; while cash flow statement depicts movement of cash for the period. However, your income and loss statements don’t necessarily correlate to your cash position. For example, you may have completed sales and reported it as revenue, but you might not have collected the cash so it will be part of its receivable. On the other hand, you may have a substantial cash balance that may not be a result of sales but raised significant cash from debt or equity financing.

Q. What Does a Cash Flow Statement Tell?

Cash is the lifeblood of your business. Your cash flow statement shows you the money that comes into your business, the money that goes out and money that is kept in the business to pay daily expenses. It has three main components – operating, financing and investing activities. Keep in mind that your company can be profitable, but still not have a positive cash flow.

Q. What Is Depreciation, Amortization and the Capital Cost Allowance?

Depreciation and amortization represent the allocation of the cost over the useful life of an asset. The term depreciation is normally associated with tangible assets, such as, building, equipment, furniture and fixture; while amortization is typically associated with intangible assets, such as, copyrights, trademarks, goodwill and patents.

Capital Cost Allowance (CCA) enables you to claim depreciation expenses for calculating taxable income under the Income Tax Act (ITA) but it is not mandatory. The ITA sets the depreciation rates for each type of asset. For example, equipment will depreciate at a 20 per cent declining balance method. However, if you choose not to claim CCA, you can establish an accounting policy to use either a straight line method or a declining balance method to calculate the depreciation of your assets.

Taking Time to Understand Your Statements

While taking time to learn and understand your financial statements is wise, it can be tough to understand all of the nitty gritty details. One way to learn more and get more from your financial statements is to meet with your accountant for a financial checkup once a year to explain in plain English what they consider your key numbers and how they affect your business.

About Nafees Chaudhry

Nafees Chaudhry is the founder of Chaudhry Nafees & Company (CNC). Nafees holds two accounting designations, CGA and CMA. CNC is a full service accounting firm that provides accounting, taxation, advisory and part-time CFO services. CNC also offers business coaching services to new startups and established businesses. As a financial advisor we will help you to grow your business successfully. We provide support, tools and mission critical reports in a timely manner so you can make sound business decisions.